Can Central Bankers Keep Markets Afloat? Year End Commentary

A timely rally in the last two weeks of the year and enormous amounts of Federal Reserve stimulus enabled major U. S. equity indexes to escape the fate that befell virtually the entire rest of the world. By interesting coincidence, the S&P 500 closed 2011 at 1257, exactly where it closed 2010. A small dividend resulted in the S&P providing a positive return in contrast to the average U. S. stock's decline of 6% for the year. Even that loss was far better than the damage done worldwide. The Dow Jones World Index (excluding the U.S.) lost 16.3%. Against such a difficult backdrop, our client returns in the low single digits were at least a minor victory. This result marks the twenty-fifth time in its twenty-six year history that our controlled-risk/flexible allocation process has earned positive returns. We lost a perfect record in 2008, when clients' portfolios lost a fraction of one percent with the S&P 500 down 37%.

Despite the many trillions of dollars of wealth wiped out in 2011, world governments and central banks warded off the danger of systemic collapse with a flood of newly created money. While re-liquifying banks in greatest danger, the lending countries involved (including the U.S.) greatly weakened their own balance sheets. Debt downgrades were commonplace around the world. As downgrades proliferated, governments increasingly denigrated the ratings services. Notwithstanding their checkered history through the subprime mortgage debacle, the ratings services are merely pointing out the obvious: Financial stability has deteriorated dangerously as countries throughout the world attempt to counter the logical consequences of excessive debt. The most important question facing investors again in 2012 is whether or not that debt peril can still be controlled.

The record amount of stimulus provided by the Federal Reserve has kept the U. S. from falling into the recession that is apparently beginning to grip the eurozone. There is discussion of yet another round of stimulus. While corporate profits were strong in 2011, and analysts are forecasting another year of profit growth in 2012, year-ahead forecasts are being ratcheted down by a great many companies currently announcing their fourth quarter results. Productivity remains strong, which is great for corporate profits, but a negative for employment. While improving slightly, the nation's unemployment problem remains severe. Interest rates have declined to historic lows, which lowers business costs but penalizes savers, and the Fed has pledged to keep short rates near zero at least through mid-2013. If all other global factors remain static, U. S. stock prices are not unreasonable, with valuations in the aggregate high but not as extreme as they have been through most of the past decade and a half.

Unfortunately, it is highly unlikely that conditions around the world will remain as they are. Leading indicators for Europe and the major Asian countries are declining. China's economy, the engine of growth for much of the world, is slowing. Its stock market, down by more than 60% from its 2007 peak, is screaming loudly that something is not as sanguine as the bullish government statistics proclaim.

The most immediate problems lie in Europe, where bankruptcy is pending in Greece. No one seriously believes that Greece can survive without a succession of sizable bailouts from stronger European neighbors and possibly China and the International Monetary Fund. It is completely unknown whether or not the political will is sufficiently widespread to generate such a rescue. If Greece or another fragile European nation should default, the consequences are unpredictable. Banks that hold the defaulted bonds could in turn fail, setting off a domino effect which could expand far beyond Europe. Billionaire hedge fund pioneer George Soros has characterized the current crisis as more severe than that of 2008, which would have led to a worldwide financial collapse but for history's greatest-ever government bailout.

The debt crisis that we began to warn about in the late-1990s is coming ever closer to its denouement. We can't know whether we will experience sovereign defaults in the year ahead or whether governments will again succeed in "kicking the can down the road" for a while longer. Which course unfolds will have a huge influence on equity potential in 2012. The hope for the world's markets is that governments and central banks will again provide the needed rescue money. While it could work, such an expectation is hardly a sound basis on which to make investment decisions.

When we made the case in the late-1990s that stocks were about to enter a long weak cycle in which equity profits would be scarce, we wrote that such cycles over the past 200 years have on average lasted about a decade and a half. Our caution at the time was that this one might last even longer because the excesses built up in the prior long strong cycle were more severe than any before. More debt than ever before had accumulated relative to the size of the economy, and valuations had soared far above any others in history. Notwithstanding strong stock market returns in 2009 and 2010, the performance record for stocks century-to-date is weak, as indicated in the table below.

Annualized Returns for the S&P 500For the Periods Beginning in the Following YearsThrough December 31, 2011

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

2.1%

15.1%

14.1%

-1.6%

-0.3%

2.3%

2.6%

3.6%

6.2%

2.9%

1.5%

0.6%

Barely more than one-half of one percent per year has been made in stocks since the beginning of the century. We are pleased that our clients' portfolios have grown by more than 65% over that time before fees, which vary by portfolio size. There have been two powerful rallies in the long weak cycle that began in 2000. The first, from 2003 to 2007, convinced many investors and analysts that the bear market from 2000 to 2003 was a stand-alone event and that the bull market that began two decades or more earlier was back in force. Over the past three years, rising stock prices have again convinced many investors and analysts that the worst is behind us and that a new long-term bull market has begun. At the very least, the advance has been durable enough that turning bullish at the right time could have made money. It is instructive to note, however, that very few investors who profited in the 2003 to 2007 rally were astute enough to retain those profits through the 2007 to 2009 decline. Since we consider it unlikely that the long weak cycle has ended, we believe that it is similarly unlikely that beneficiaries of the rally that began in 2009 will ultimately retain those gains. While valuations have declined somewhat from their extremes, the underlying debt situation has worsened. Over the past two centuries, equity markets have never begun a new long strong cycle in the absence of ultra-cheap valuations and with debt levels still at excessive levels. It is improbable that historical precedent will be broken in the current instance unless governments and central banks abandon the fight against debts and simply print so much money that inflation minimizes the debt burden. Because that action could become the long-term solution, we have begun to build a position in gold that would benefit from significant inflation, unlikely as inflation looks at present.

Many investors typically choose to put their money in the asset class that has most recently performed best. Even with interest rates beginning 2011 at extremely low levels, the Federal Reserve's move to buy bonds directly and push rates even lower led to good bond returns over the full year. Because bonds have also marginally outperformed stocks over the past 30 years, there is an increasing tendency to move money into fixed income securities to sidestep the volatility that has plagued stocks in recent years.

High quality bonds could perform well in 2012 if we experience a recession or other deflationary or disinflationary event, which would probably be bad for stocks. If rates remain stable, a ten-year U. S. Treasury note will return about 2%, its current interest rate. If the economy strengthens, interest rates will likely rise and bond prices fall. Should debt begin to fail around the world, interest rates on secure bonds could plummet and prices rise. Because of default risk, lower quality bonds could conversely see interest rates soar and prices collapse.

While we believe that the ultimate resolution of the debt crisis will involve significant levels of money printing and substantial inflation, we would be surprised to see that unfold over the next year or two. More likely, it will come further down the line. We consider a disinflationary -- even deflationary -- environment more likely in the short run, which would be best for top quality bonds. With yields so low, however, the reward for being right about bonds in the year ahead is relatively small. Should yields rise for any reason, however, even top quality bonds could lose money this year and for several years ahead. When bond yields began their last long rising phase, even unmanaged Treasury bills outperformed bond total returns for more than four decades from the early-1940s to the early-1980s. Although we anticipate the likelihood of a disinflationary environment this year, we are not recommending bonds because the reward for being right about bonds is significantly less than the penalty for being wrong. Even if investors should profit in bonds this year, they will only retain those profits if they eventually make a timely sell decision before aggressive money printing promotes significant inflation. From current interest rate levels, the odds are against bondholders over a multi-year time frame.

We enter 2012 with great fragility in the world economy and great uncertainty in world markets. Should governments and central banks fail to maintain investor confidence, the possibility exists for waterfall price declines. That prospect poses great danger to traditionally allocated stock and bond portfolios, but it presents the potential for great buying opportunities at far lower prices for investors properly anticipating such an outcome. That scenario need not unfold this year, but the unraveling of the eurozone could precipitate it. Stay alert!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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